2016-01-25

Michael Pettis on China's Supply Side Reforms; China's Path Forward

Well worth the read for anyone interested in the Chinese economy, particularly those wedded to mainstream, orthodox economic models.

This comes very close to my view on depreciation of the renminbi, which is based on China's previous credit growth, a monetary easing cycle, a U.S. dollar rally and mismatched capital flows in the past (anyone who wanted to invest in China could do so, only some who wanted out could move capital abroad).

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.

Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade data confirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.

The final reason to expect devaluation, amid a crisis, would be as a last resort to stop deflation.

I will argue that most economists have an incoherent understanding of China’s rebalancing needs, and for this reason many if not most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant. This is going to be a long post, so for those who want the 9-point summary:

China’s economic growth is not decelerating as a natural consequence of the aging of China’s growth model. It is decelerating for three reasons. The first reason is the reversal of the growth process by which China’s imbalances have reached their systemic limits.[1]

The second reason is that during the phase of rapid growth, China’s balance sheets, as occurred in every similar case, evolved to become highly inverted, and just as this automatically caused growth to be higher than expected during the expansion phase, it must cause lower-than-expected growth during the contraction phase.

Finally, the economy must shift, one way or another, from one of rising leverage to one of declining leverage, and with rising debt the only thing propping up growth levels, deleveraging cannot help but cause growth to drop.
This means that regardless of trends in underlying productivity, growth must slow sharply, and it will, either smoothly and continuously, or in the form of higher growth early in the adjustment period and a collapse in growth later.

The growth deceleration can be temporarily countered by rapid increases in debt, but ultimately this will only increase future deceleration, with a rising chance that the shift will be disruptive. Every growth miracle in history has been followed by an unexpectedly difficult adjustment, and it is unreasonable to have expected that China would be any different.

The only way to minimize the costs of the adjustment is to take steps to speed up the rebalancing of demand and the repayment of debt. This must be the direction of reforms if Beijing is going to reduce the costs of adjustment and the risk of a disruption.

Repaying debt simply means allocating debt-servicing costs, either directly or indirectly, to specific sectors within the economy. This will either occur in ways targeted by policymakers, or if postponed for too long, it will occur in unpredictable ways determined by circumstances. For example default allocates the costs to creditors, inflation allocates the costs to household savers, economic collapse and high unemployment allocates the costs to workers, etc.

By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.

Beijing has already tried to address its growth problems by implementing the productivity-enhancing reforms beloved of orthodox economists, but while these might be a good idea in normal times, they will have almost no effect on reducing the cost of China’s economic adjustment.

Later he goes on to quote Say's Law and comments:

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services.

China is suffering from debt-fueled malinvestment. It has a large amount of debt backing overvalued assets (capital goods) which are in the wrong industry or location in the case of real estate. The fear of default and lost jobs kept capital flowing even when it was obvious these firms were zombies. Even if the debt could be wiped out by a magic wand, there's still the problem of malinvestment, of these assets being in the wrong industries.

In the short-term, the total capital and labor in the economy is relatively fixed. When there is a large amount of capital and labor in the wrong sector due to political intervention or money printing by the central bank (or both), it leads to a deviation from the natural or free economy. Entrepreneurs and consumers are not responding to market signals, they are responding to artificial signals such as artificially low interest rates. Eventually, these artificial signals or forces cannot be maintained and there is a bust; the size of the bust is proportional to the boom before it.

My simple model of the Chinese economy is that it could achieve a lot of growth with central planning because a lot of basic growth involves governments, and China was way behind. Even in the free market West, roads, airports, subways, hospitals, schools and industrial parks involve some government insolvent in most cities and towns. Furthermore, these projects are relatively straightforward in terms of implementation, and when you're starting from a very low base, almost any project is going to positively increase GDP and also be profitable an investment. By the mid- to late-2000s, however, China was heading for the middle income trap. It was running out of easy low hanging fruit. If you'd been in China in the past decade plus, you might be familiar with huge empty highways and empty cities such as Pudong that later filled up. It didn't take a rocket scientist to see the infrastructure investment was running ahead of the economy. Eventually, some areas of China would be stuck with no infrastructure needs for a couple of years, or it would be saddled with pure malinvestment, buildings and roads that would never be used due to slowing population growth and migration out of the area. Instead of rebalancing in 2008 when the economy was hit with a shock, the government doubled down on the old model. Huge debt was run-up an infrastructure development sprang into overdrive at the worst possible moment. China is only now dealing with the cleanup, having spent several years gently applying the brakes.

As Pettis notes in the piece, one big way the government can ease the transition is to shift state assets to the people. Andy Xie and others have called for this as well, in Xie's case with the government transferring SOE shares to the people (which could be done directly or indirectly). The key stumbling block is government officials who profit from economic control. To take a political turn, as part of the economic transition the CCP should focus more on politics, and not as much on economics. They do not need to increase democracy or engage in any type of political reform, instead the government should be exiting areas where its control is weak, such as the economy. No government can tightly control the economy and break the middle income trap, and governments can never fully control market forces. Trying to control the economy sets up a government for failure. There is a role for the state in setting tax policies and dealing with the transition, but on the other side the private economy should emerge with a greater role in the economy, if only because capital is transitioning out of state dominated sectors and into more privately directed sectors.

Large governments become weaker as they grow larger because they focus and power diminishes the further away from the center. As the Chinese saying goes, the mountains are tall and the Emperor is far away. In contrast, small governments can be extremely powerful because they focus on a smaller range of issues. Ideally for the CCP, China would emerge from the transition with more economic freedom, but a more powerful central government with a tighter focus on political issues.

In conclusion, China has a lot of supply, but in the wrong places. It needs to increase the supply in other sectors, which will be accomplished most efficiently by the private economy. The economic stumbling block is a large amount of debt which could cause a financial crisis. The bill must be paid one way or another, politically determined if the government moves in time, by the market otherwise, with a big currency devaluation as the last resort. The political stumbling block is insiders who joined the CCP to get rich, or who want the CCP to maintain economic control. The former are more likely to engage in corruption and many were swept up in the anti-corruption campaign (Pettis Says China Has 2 Years to Adjust; Xi Must Consolidate Power), but there will still be ideological resistance to shifting economic power to the people.